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Emerging markets

17 Feb 2017

The EM debt rout that wasn’t

Emerging market debt investors are used to quick reversals of sentiment towards the asset class even as longer-term trends suggest there is little reason for panic

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Emerging market debt investors are used to quick reversals of sentiment towards the asset class even as longer-term trends suggest there is little reason for panic – exemplified by the wobble induced by Donald Trump’s shock victory in the US presidential election last year.

As markets priced in the former reality TV star’s ‘America First’ platform of tax cuts, a splurge on infrastructure projects and the imposition of protectionist trade measures, emerging market bonds sold off. At the same time, US Treasury yields rose, the dollar strengthened and market-based expectations of monetary policy tightening by the Federal Reserve (Fed) hardened.

This backdrop led some observers to herald a period of volatility and negative returns for emerging market debt.

We disagreed. While recognising that the Trump administration had sent a wave of uncertainty across many emerging economies, we did not believe the underlying economic fundamentals for most of these nations had changed appreciably.

With the exception of Mexico, we expected stronger growth across emerging markets in 2017, supported by higher commodity prices and domestic spending. Moreover, we believed markets were neglecting to factor in a dilution of – or at least delay to – protectionist and reflationary US policies.

EBBING ANXIETY

As a result of our more constructive views, in December we forecast returns of 8% to 12% for local-currency debt markets this year, based upon a starting yield of 6.8%, moderate currency appreciation and lower interest rates in key markets such as Brazil, Colombia, Russia and Argentina.

In fact, the asset class has generated returns so far this year that, should they continue, are set to surpass our expectations. These gains have been accrued as concerns by emerging-market debt investors over a number of post-election phenomena have ebbed.

One of the biggest sources of anxiety was the strength in the US dollar, which in December rose to a 14-year peak against a basket of its major rivals. Dollar appreciation increases the debt burden for emerging market countries and companies that have borrowed in the currency.

This year, though, the greenback has retreated somewhat as investors wait for the Trump administration to carry out its economic programme and for signs of the ‘reflation’ that it could spur, by fanning growth and inflation. A decline in US Treasury yields has also weighed on the dollar, as well as helping to lower rates on emerging market bonds. This has taken place amid a tempering of investor expectations for immediate and aggressive policy-tightening by the Fed.

Even though US economic data have remained positive, meanwhile, the figures out of Europe and most emerging economies have also been robust. Citigroup’s economic surprise indices, which track how data compare with economists’ forecasts, have risen for Europe, China and the US over the last few months. It is also worth noting that the US dollar, whose rally began in 2014, is constraining US exports.

Elsewhere, commodity prices bottomed out in 2016 due to a drop in supply and a moderate firming of demand. Those price gains have broadly been maintained this year, leading to an improvement in the balance of payments for exporter nations.

TRUMP TALK

While there have been lots of rather bombastic comments from the president and his cabinet picks, these have elicited a strong pushback from Congress – including a number of Republican officials – the courts and general public. In addition, the Trump administration is generating confusion over its plans for a border-adjustment tax; the proposed wall with Mexico; whether it desires a strong or weak dollar; and who exactly it deems to be its allies and enemies.

The greatest threat to emerging economies is trade protectionism, the prospect of which Trump has raised by seeking to withdraw from trade agreements and impose tariffs. Although such action is still in its initial stages, we believe the president is more interested in ‘headline’ victories than a wholesale departure from the previous orthodoxy on trade, which would likely trigger retaliatory measures by trading partners and opposition from vested interests.

These factors, when taken together, reinforce our view that the bout of investor anxiety over emerging market debt late last year was misplaced. They also suggest that local currency bonds may provide similar returns in 2017 to those notched up last year.

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